After a rocky start to the year, the financial markets settled down mid-February with oil and U.S. equities rebounding in the latter half of the month. The foreign equity markets have rallied a bit, but are still in a funk.

Bond yields remain at historic lows. The 10-year Treasury yields 1.8 percent, which looks positively mouthwatering compared to Japanese and German government bonds that are flirting with negative yields.

Dipping into the Permanent Fund

As everyone knows, Alaska is facing some difficult fiscal decisions as a result of plunging oil prices and declining production. Approximately 90 percent of general fund revenue is directly tied to oil.

Oil is just over $30 a barrel and the Department of Revenue is assuming $60 a barrel for budgeting purposes. At the $60 level, the state faces a $3.5 billion budget deficit both this year and next. We are spending $5 billion and taking in $1.5 billion. At current spending levels it would take a price of $115 per barrel to balance the budget.

What to do? Well, we can’t just cut out $3.5 billion. The state’s annual domestic product, or GSP, is around $50 billion so $3.5 billion is 7 percent. Reducing spending by 7 percent of GSP (even forgetting about multiplier effects) would be disastrous. The Great Recession of 2008 saw the U.S. economy fall just over 4 percent and that was pretty scary, pushing unemployment up to 10 percent.

The state has saved a lot to help us get through this current crisis, something we didn’t do in front of the economic crisis in the late 1980s. But we’re burning through that savings quickly. At current rates it would be gone in several years.

There are three plans for addressing the budget crisis that are currently being debated in Juneau. I won’t go into the details, but all three draw on the Permanent Fund. The Governor’s plan (SB 128) is a bit more complicated (and comprehensive) than the other two (SB 114 and HB 224). Let’s ignore that in the interest of simplicity.

Callan Associates, the longtime consultant for the Permanent Fund, was in town a few weeks ago and analyzed what these three plans would mean for the Fund.

The firm analyzed the impact on the Fund of drawing roughly 4 percent to 5 percent net out of the Fund (actually the Realized Earnings Reserve) each year, depending on the plan. The Fund’s expected return over the long run is 6.9 percent, so that seems doable and would leave enough room for the fund to grow, albeit slower than before.

To get a handle on how market volatility would affect the analysis, Callan ran Monte Carlo simulations over several thousand future market scenarios to look at the dispersion of results over 10 years for each plan. (APCM uses this technique for modeling balanced accounts and the probabilities of reaching horizon goals. It’s standard operating procedure in the asset allocation business.)

Guess what? It looks like all three plans are reasonable and leave the Permanent Fund with a median real value of just over $50 billion at the end of 10 years — about where it is today.

Each plan can withdraw at least $2 billion per year from the get-go to help with the budget deficit. A combination of cuts and tax increases would need to be debated and adopted to close the remaining $1.5 billion deficit. While tapping the Permanent Fund is not a perfect solution, doing so would buy some time to consider other options.

What about the Permanent Fund Dividend? The Governor’s plan provides for a $1,000 dividend this year, followed by modest declines as oil production decreases over time. The other two plans allow for the existing dividend formula to play out for a year or two and then it will probably be up to the Legislature to decide if future dividends are feasible.

If it is decided that the Permanent Fund should be used to help close the budget deficit, using the current payout method for the annual dividend would likely prove unsustainable. Under current laws the Legislature can only distribute earnings from the Fund for any public purpose (including dividends).

However if there are no earnings reserves it would require a constitutional amendment (and vote of the people) to make a principal distribution. There is no easy or perfect answer in this situation, but moving forward with a plan that balances the budget over time is best done sooner rather than later.